When you start dealing with cryptocurrencies, you’ll inevitably encounter the term “stablecoins.” Its meaning is pretty straightforward: that’s the coin linked to a stable asset (mostly, a US dollar or gold). But how is it technologically possible and how to use these tokens? Check this guide for the answers.
Stablecoin vs. Volatile coin: What’s the difference
You may think that a stablecoin is something that guarantees certainty — but the stability behind this token is pretty illusory. The stablecoin price is not fixed once and forever, and it may turn out to be a shitcoin that doesn’t have any real value. However, compared to the volatile cryptocurrencies that can increase by 500% and then dramatically fall down within a year, the stablecoin brings a bit more predictability to the fast-changing cryptoworld. It keeps its purchasing power and reduces the inflation chance to a minimum. These traits are possible due to the stable valuations of an underlying asset, or its external reference.
How stable is a stablecoin
The stability of the stablecoin depends on the stability of its reserve asset. Any problems with the underlying asset affect these tokens. For example, most stablecoins linked to gold appeared to be shitcoins. But once pegged to fiat currency, the tokens become much more reliable. Their stability is still questionable, though. For example, it’s unlikely that Tether USD has a complete backup by its reserve fiat currency. As Financial Times observers found out, the 2021 report on Reserves Breakdown shows that only 2.9% of Tether USD is backed by cash. Nevertheless, this cryptocurrency still has the greatest market capitalization by the end of May 2021.
Top 5 stablecoins (by May 28, 2021)
Tether USD. The first and most widely stablecoin linked to a US dollar. Market Cap: $61,212,475,876.
USDC. Market Cap: $21,985,351,100.
BUSD. Market Cap: $8,707,435,946.
Terra USD. Market Cap: $1,967,071,673.
DAI. The most popular crypto-backed stablecoin popularized by MakerDAO. Market Cap: $453,161,226.
3 methods of making a stablecoin
1. Linked to a set up “reserve.” In most cases, the entity, being an individual custodian, creates an asset reserve to secure a stablecoin. That’s how the peg to fiat currency is created: one million US dollars back up one million of a linked stablecoin. Alternative collateral reserves can be commodities and precious metals. The 100% reserve appears to be an ideal scenario, though: the above-mentioned case of Tether USD brings more clarity to the facts on the ground.
2. Collateralized by other cryptocurrencies. If another cryptocurrency covers stablecoins, overcollateralization is needed to protect them from volatility. DAI from Maker is the most illustrative case here. This stablecoin has 150% support from Ether (ETH), a native cryptocurrency for Ethereum blockchain.
3. Algorithmic methods. Algorithms and smart contracts manage the token supply: depending on the price fluctuations, they are either burned (to increase the value) or created in an extra amount (to decrease the price). The experiments with algorithmic stablecoins are not successful to date, though.
Basis stablecoin, the most popular token of this type, had an underlying consensus mechanism on controlling the supply. Nevertheless, the project was closed due to governmental regulatory constraints.
The technical side of making stablecoins
Stablecoins possess the basic traits of cryptocurrencies:
- blockchain-based (most popular stablecoins are Ethereum-based ERC-20 tokens),
- no central bank involved
- transacted peer-to-peer
But how is it possible to build the link with an underlying asset? Technical specifics differ with the methods. In the case of a set-up off-chain reserve, the centralized entity holds the collateral and issues stablecoins. Regular audits ensure the trustworthiness, and the token redemption is the issuer’s responsibility.
Cryptocurrency-backed stablecoins use the basket of crypto-assets as collateral. It means the presence of smart contracts that regulate the reserve protection for the stablecoin. In the DAI case, there exist publicly visible reserves that are decentralized and relatively stable, thanks to sufficient overcollateralization. This way, the supply of stablecoins depends on the underlying asset’s size.
The approach to creating algorithmic stablecoins includes supply calculations based on the current trade. If the price falls below $1, coin holders are encouraged to purchase bonds (a separate token class). The coins spent are burned to decrease the supply and increase the price. If the price increases above $1, extra tokens are minted and distributed among separate token classes.
Advantages of stablecoins
- Minimized price volatility. Stablecoins cover the value and necessity of a safe coin in the blockchain.
- Back up mechanism. Stablecoins have a stable asset or a clear algorithm behind.
- Blockchain-based. Possess all the cryptocurrency advantages even when linked to fiat currency.
- Liquidity. Can be used in cryptocurrency exchanges.
- Secure. Stablecoins can be used for transactions and entering the crypto market.
Risks of using stablecoins
- Price fluctuation. The cryptocurrency can still fluctuate against its reference asset, especially if stablecoins are crypto-collateralized.
- Insufficient backup transparency. In the case of centralized entity-issued stablecoins, it’s hard to trust a custodian. The supply of stablecoins can be manipulated, as it happened to Tether USD.
- Risk of hacks. Stablecoins are blockchain-based and vulnerable to hacks and crashes.
How to use stablecoins in the lending protocol
In most cases, you’ll receive stablecoins as the borrowing asset in a lending protocol. Thus, you can use them in your long and short investment strategy, or take advantage of price increase or decrease of a volatile cryptocurrency asset. In this case, always take an eye on the sufficient overcollateralization of your debt — otherwise, the liquidation process can take place.
Some platforms provide an opportunity to deposit stablecoins. Depending on the platform, you can receive around 10-20% interest. This way, stablecoin can serve as an easy entry-point to understand, learn how to make profit, and trade in the cryptomarket.
And remember: whichever investment decision you make, always do your independent research first!